License agreements are the cornerstones of intellectual property-based technology companies.
License agreements are the cornerstones of intellectual property-based technology companies. A license agreement is a legal contract between two parties, known as the licensor and the licensee. The licensor grants the licensee a right of use and a limited license, while the licensee accepts a series of conditions relating to the use of the product and the payment for such use.
How is the license evaluated?
The value of the license is the amount for which the “grantor at will” sells the license to the “licensee at will”. However, how do the parties know how much to ask or how much to pay for the license? How do companies know if investing in a certain license is worth it? These questions are particularly relevant for licenses which will not bear fruit until a few years later.
Because of the difficulty in gauging the value of a license when executing a contract, its value is usually set as a percentage of the sale of products that are based on the invention for which the license is granted. These percentages are called “royalties” and are a model for distributing profits between inventors and technology companies that use the invention to make and market products.
How is the royalty rate set?
Due to the difficulty in calculating the royalty rate, several rules of thumb have been established for determining the royalty rate, by industry and product, as well as a comparison of the usual royalty rate for similar products and transactions. similar, called “benchmarking.” Understanding the source of these rules of thumb will be very helpful in cases where setting the royalty rate is a challenge.
The first rule to define the royalty rate for a license to use intellectual property is the “25% rule”. This rule provides that the royalty rate that a user of the intellectual property of others must pay to the owner of that intellectual property is 25% of the operating profit of that product.
The 25 percent rule assumes that the licensor and the licensee must share the profits from the use of the license, and the licensee accepts most of the profits (75%) as the paying party. Most of the expense and, in turn, most of the risk. .
Therefore, under the 25% rule, in industries where the average operating profit is around 12% (such as the chemical industry), the average royalty rate is around 3%. In an industry where the average operating profit is around 18.5% (such as the medical products industry), the average royalty rate is around 4.5%. Finally, when the average operating profit in a certain industry is around 26% (like the pharmaceutical industry), the average royalty rate is around 6.5%.
A study presented in the famous article by Robert Goldscheider (some refer to him as the 25% rule, ie the “Goldscheider rule”), which studied 15 of the world’s leading industries as well as licensing agreements successes between the years 1980-2000, revealed that the external royalty rate was 4.3%, which represents about 26.7% of the average operating profit.
A subsequent study by the Global Valuation Institute of the accounting firm KPMG, in 2012, tested the validity of the 25% rule and the extent of its use, at the typical royalty rate in 14 leading industries. The study found that even in the years following the Goldscheider article, the royalty rate for licensing continued to meet the 25% rule.
However, the KPMG study also found that the 25% profit rate comes from a company’s EBITDA (earnings before interest, taxes, depreciation and amortization). Using EBITDA instead of operating profits results in a more precise distribution of company profits, as they come from the license contribution. In effect, this eliminates from the equation mathematical and financial considerations which are not necessarily linked to the contribution of the license to the profit made by the product based on the license.
In conclusion, understanding the source to determine the royalty rate is an important first step in its calculation. The assessment of the actual royalty rate depends not only on the usual profit or EBITDA in the relevant industry, but also on additional factors such as the size of the market targeted by the product, the date of entry of the product into the market and the investment required until the product hits the market.